Investing is emotional business; anyone who believes differently hasn’t been through a financial crisis like the one that the global health crisis is inducing. From the longest recorded economic expansion to what could be the worst recession since the Great Depression, it’s been a year of turmoil.
“Couple this with the fact that this is an election year, and an especially controversial election year on top of it, and you’ve got a recipe for an emotional decision-making disaster,” says Jordan Sowhangar, a certified financial planner and wealth advisor at Girard in Souderton, Pennsylvania. “Advisors need to be in tune with what biases their clients may fall into as investors, and educate, coach and guide them before, during and after emotionally charged events, like the 2020 pandemic.”
The study of these biases is known as behavioral finance. “Behavioral finance techniques are essential tools in an advisor’s toolbox,” says Van Truong, vice president of Financial Planning at Citizens Financial Group in Canton, Massachusetts. They improve your emotional intelligence, which financial advisors need in highly emotional circumstances. Behavioral finance also “helps your clients focus on managing their investing behavior that contributes to long-term success.”
What Is Behavioral Finance?
Behavioral finance is the study of psychological biases that can influence investor behavior and by extension the stock market. “(It) is about understanding how people make decisions,” says Kate Mielitz, accredited financial counselor and assistant professor of family financial planning at Oklahoma State University. “People are not rational, and because we are not rational, we don’t make perfect economic decisions.”
Not only are we inherently irrational, but we’re also highly emotional beings. We assign emotions to our financial decisions which can impact our financial decisions, Mielitz says. If you get an inheritance, you’re apt to treat it differently than pay from a job, even though both are just a form of income.
Truong sees behavioral finance as the integration of three disciplines: traditional finance, human psychology and neuroscience.
“While advisors are not scientists or psychologists, without some basic understanding of how the human brain works and recognition of common decision-making biases, it will be difficult, if not impossible, to make clients act on our best advice and recommendations,” she says.
Since investor behavior drives the stock market, behavioral finance is also necessary to help advisors understand the financial markets and help their clients better navigate those at times mercurial waters.
Behavioral Finance Biases
Inherent and learned psychological biases can influence financial decisions. The reason investors are apt to treat an inheritance differently than income from a paycheck is the mental accounting bias, Mielitz says. When you find $50 in your coat pocket, you’re more inclined to use it frivolously even though, rationally, it’s just like any income you earn.
There are many biases that influence financial decisions in addition to the mental accounting bias. These behavioral biases include:
— Confirmation bias.
— Regency bias.
— Herding mentality.
— Aversion bias.
— Familiarity bias.
The primary bias discussed in behavioral finance is confirmation bias, or the fact that “we seek out information that confirms the way we already think,” Mielitz says.
When making a new decision, investors are apt to seek counsel from those who think like them. “If you are considering a first-time contribution to your retirement plan, you are going to seek out someone who already contributes to theirs because you want to hear why what you are doing is right,” Mielitz says.
Of course, this is a positive example, but confirmation bias can also lead to negative results. Investors inclined to time the market might be particularly susceptible to this bias, says Zach Conway, managing director of Conway Wealth Group at Summit Financial in Parsippany, New Jersey. In the absence of crystal balls, “we use whatever data we feel fits the story of either coming up or down cycle.”
Perhaps the most pernicious aspect of confirmation bias is its resilience, he says: “Despite evidence mounting to the contrary, those suffering from confirmation bias will seek any remaining shreds of evidence to support and confirm the story they remain determined to tell.”
Regency bias can also play into this, wherein investors place too much emphasis on short-term trends. “As we’ve seen most recently in the bull market, prior to correction, the longer a trend continues, the more investors believe the trend is infallible, making the sudden downturn in March therefore even more jarring,” Conway says.
Another common behavioral finance bias is herding mentality. People like to follow the crowd, either out of a desire to be a part of what others are doing or out of a fear of missing out, Sowhangar says. She often sees herding behavior in her practice when clients want to discuss a particular stock they keep hearing about from friends or co-workers.
“Those who study and follow behavioral finance tend to argue that this type of herd behavior can lead to ‘bubbles’ in the market or at the very least can lead to sell-offs or rallies in the market that are not otherwise necessary,” she says.
Just as investors fear missing out, they’re also afraid of losing money in the stock market. In fact, they’re so afraid they may let loss aversion bias lead them to be too conservative with their money. Loss aversion could also prompt them to stick to investments they’re already familiar with, which ties into the familiarity bias, Sowhangar says.
Behavioral Finance Techniques for 2020
The volatility of 2020 is the perfect time to put behavioral finance techniques into practice.
“To incorporate behavioral finance (properly), advisors need to be a client’s financial therapist as well as their financial advisor,” Sowhangar says. You must establish an emotional connection with your clients that goes beyond the numbers. Listen to their fears and instead of dismissing them, acknowledge them as valid concerns, she says.
“As your client’s financial advisor, you also have a vital role to play as an educator and level-headed guide,” she says, noting that she’s used this strategy to combat herd behavior and loss aversion bias this year.
“Communication is a key to any relationship, and a crisis doesn’t change that fact,” says Mark Schrader, a financial planning strategist at TIAA in Charlotte, North Carolina.
Use this as an opportunity to reach out to clients, and refocus their attention from the potentially alarming news that may trigger behavioral biases and back to the importance of sticking to their financial plan. “If you aren’t talking to your clients about their positive money topics they will focus on what info is available,” Schrader says. This is usually sensationalized news broadcasts and social media posts, which are not conducive to rational decision-making.
Clients need a sounding board to help them avoid rash decisions based on confusion and fear, Sowhangar says. “It is the advisor’s job to help the client tune out which noise is simply inducing fear versus helping to make a necessary decision.”
Another behavioral finance technique she sees advisors use during the pandemic is helping investors get a “behind-the-scenes” look at their portfolios. When investors see others making changes to their investments, herding mentality can make them think they need to make changes, too.
Letting your clients see the changes your team is making in their portfolios, no matter how small, can help clients feel reassured that something is being done and prevent them from making more drastic and emotional changes, Sowhangar says.
What advisors should not do is let their clients dictate portfolio allocations.
“It’s our core responsibility as advisors to know our client’s true tolerance for risk, coach toward a long-term plan and guide away from the fear and greed-based instincts that result in illogical and damaging financial decisions,” Conway says. “Rather than overthinking the complexities of human psychology, we need to get back to the basics of understanding risk tolerance.”
At Citizens Financial Group, they use a wealth allocation framework that looks like Maslow’s hierarchy of needs to help clients prioritize their financial goals from needs to desires and dreams. Truong says this has been working well for their clients.
“As an advisor, we don’t know what will happen to the economy and the financial market tomorrow, next month, and next year,” Truong says. “Our job is to help our clients make sound financial decisions that will prepare them for the certainty of uncertainty.”
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Behavioral Finance Techniques Advisors Are Using in 2020 originally appeared on usnews.com